New Kid on the Block: Crowdfunding Joins Traditional Equity-Based Funding Options for Start-ups & SMEs

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New Kid on the Block: Crowdfunding Joins Traditional Equity-Based Funding Options for Start-ups & SMEs

October 19, 2015

By Danielle Daigle, Associate at McInnes Cooper,
Chris MacIntyre, Partner at McInnes Cooper

Access to sufficient capital to fund operations, research and development, and other costs is a key challenge for start-ups and for some small and medium sized businesses. There are several typical sources of capital from which start-ups and SMEs can choose. Equity-based funding can be a bit tricky to navigate because of the securities law requirements that include filing a prospectus, a time consuming and costly process. The key for start-ups and SMEs is to fit the equity issuance into an exemption from the prospectus requirement – and a new alternative just became available. In May 2015, several Provincial securities regulators implemented a new start-up crowdfunding exemption, creating another option for start-ups and SMEs to raise equity capital in those Provinces.

Here are three key sources of capital for start-ups and SMEs, and three key sources of equity-based funding – two traditional and the new equity crowdfunding option – and some pros and cons of each.

3 KEY SOURCES OF CAPITAL

Start-ups usually get capital in one of three ways:

1. Debt Financing. There are various debt financing options available to start-ups. For example, a key focus of Business Development Bank of Canada (BDC) is providing financing to entrepreneurs; there are also loan programs available through organizations like Centre for Entrepreneurship Education and Development (CEED), Atlantic Canada Opportunities Agency (ACOA) and Futurpreneur Canada. Debt financing can be difficult for start-up businesses to obtain because there is rarely much in the way of valuable collateral over which the lender can take security for its loan. Even where debt financing is available, start-up businesses might not be keen to take on the burden of debt and the obligation to continually service it through principal and interest payments. It might also require shareholders or other principals of the business to give personal guarantees and security, and this can be risky – and unattractive – to those involved.

2. Grant Funding. Depending on its nature, a start-up business might have access to grant funding through various government agencies. A big benefit of grant funding: the recipient doesn’t typically have to repay it. The challenges: there aren’t alot of them, and the recipient must take care to comply with any requirements associated with the grant – or potentially lose it.

3. Equity Funding. Equity funding raises money by issuing shares of a company to investors in exchange for capital. This type of financing is attractive to start-ups and SMEs because they don’t need valuable collateral to secure the investment, and they don’t have to incur principal or interest payments as with debt financing. However, there are drawbacks to financing a business through equity funding. The owner will likely have to give up some management oversight and control to the new investors, and obtain their consent as shareholders to certain business matters. The company will also be required to comply with securities laws. Every Canadian Province has securities laws regulating the issuance of equity securities (e.g. shares or units) to investors. One of the main purposes of these regulations is investor protection. Securities laws generally require an issuer (i.e. the company) to create and make available a prospectus – a detailed document describing a security to be issued to potential investors and disclosing other specified information – to investors, unless the issuance fits within an exemption from this requirement. A prospectus is a time consuming and costly document to prepare, so issuers – especially start-ups and SMEs – frequently try to identify and take advantage of available prospectus exemptions. The exemptions and the conditions of each are published in National Instrument 45-106.

3 KEY SOURCES OF EQUITY-BASED CAPITAL

Equity-based funding can be a bit tricky to navigate because of the securities law requirements – but many start-ups and SMEs still choose the equity funding route to raise capital because they don’t qualify for debt or grant funding. The key: fitting the issuance into an exemption to avoid the prospectus requirement.

Here are three key sources of equity-based funding for start-up businesses and some of the pros and cons of each:

1. Friends, Family and Business Associates. For many start-ups, the first source of equity based capital – outside of whatever funds the business owners themselves can cobble together – is investment by friends, family members and close business associates. The prospectus exemption in Section 2.5(1) of NI 45-106 applies to the distribution of securities to the following people:

a spouse, parent, grandparent, brother, sister, child or grandchild of a director, executive officer or control person of the company or of an affiliate of the company;
a parent, grandparent, brother, sister, child or grandchild of the spouse of a director, executive officer or control person of the company or of an affiliate of the company;
a close personal friend of a director, executive officer or control person of the company or of an affiliate of the company;
a close business associate of a director, executive officer or control person of the company or of an affiliate of the company;
a founder of the company or a spouse, parent, grandparent, brother, sister, child, grandchild, close personal friend or close business associate of a founder of the company; and
a parent, grandparent, brother, sister, child or grandchild of a spouse of a founder of the company.

To qualify for the exemption, the person purchasing the securities must be doing so as principal (that is, not on behalf of someone else) and no commission or finder’s fee can be paid to any director, executive officer or control person of the company or of an affiliate of the company in connection with the distribution of the securities to the purchaser.

On the “pro” side, this exemption is purely relationship-based, and the person acquiring the securities need not be a sophisticated investor to be able to purchase the securities without need of a prospectus. On the “con” side, however, this funding option isn’t likely to be a source of significant capital since (at least for many people) family and friends, in particular, often don’t have large amounts of money available to invest. Getting into a business relationship with friends and family members can also lead to strained relationships if the business isn’t successful or there are disagreements about how to run the business; if possible, it’s often best to segregate business and investor relationships from friendships and family ties. Nonetheless, accessing capital from friends, family and business associates continues to be an oft-used source of seed capital for start-up businesses.

2. Angel Investment. “Angel” investors, as they are known in the venture capital world, are typically savvy business people with access to personal capital who will invest in a start-up business so it can get through the initial stages of its development. They are referred to as angels because they are seen to be assisting the company in a time of significant need. These investors will often provide more than just capital, also offering input and guidance regarding the management, governance and other aspects of running the business.

Angel investors typically qualify for the accredited investor exemption set out in Section 2.3 of NI 45-106, since they will usually have sufficient assets or income to fit within the definition of “accredited investor” found in sections (j), (j.1), (k) or (l) of NI 45-106. Note, however, that under amendments to NI 45-106 that came into force earlier this year, a company distributing securities to an “accredited investor” as defined in sections (j), (k) or (l) must obtain a signed Risk Acknowledgment in the prescribed form from the investor when that investor signs the agreement to purchase the securities. To learn more about the May 2015 amendments to NI 45-106, read McInnes Cooper’s: Positive Onus On Sellers – 3 Key Changes To Prospectus Exemption Rules & 3 Compliance Tips.

Angel investment has a lot of pros for start-ups, such as giving the company access to much-needed funds and business expertise, and introducing the company to the angel’s network of other investors. However, there some cons. Angel investors can be hard to find and once you have identified them as potential investors, it can be equally hard to convince them that your start-up is promising enough for them to invest in. In addition, angel investors typically have certain expectations or “strings” attached to their investment, including regular reporting and transparency with respect to the business operations, so it’s important for companies to consider these requirements carefully when negotiating an equity financing with angel investors.

3. Crowdfunding. This newest “kid” on the equity-based start-up funding “block” has attracted a fair amount of attention, particularly over the past year. “Non-equity-based” crowdfunding has been going on for some time through websites such as Kickstarter. In “non-equity-based” crowdfunding, individual investors – the members of the “crowd” – each provide a small amount of money to finance a project or business venture, typically through an internet platform or portal and typically in exchange for products or services. In “equity-based” crowdfunding, however, the members of the “crowd” invest capital in exchange for an equity interest (such as shares), bringing securities laws into play. The existing securities laws do apply to the distribution of securities through crowdfunding, but until now the available prospectus exemptions (accredited investor, minimum amount, etc.) didn’t work well for crowdfunding.

Recently, several Provincial securities regulators responded by creating a tailored set of rules balancing the needs of issuers and investors. Effective May 14, 2015, regulators in NS, NB, Manitoba, Québec, Saskatchewan and BC implemented a start-up crowdfunding exemption relieving qualifying companies from the prospectus requirement. Each regulator published its own “order”, though they are identical in substance; read the NS Blanket Order 45-524. To learn more about crowdfunding generally, and the crowdfunding-related exemptions the regulators originally proposed in 2014, read McInnes Cooper’s: Joining The Crowd – NS & NB Consider Crowdfunding.

The new start-up exemption is aimed toward helping start-ups in particular to comply with the applicable regulatory requirements when accessing this growing source of capital. It is available to non-reporting issuers with their head office in one of the participating jurisdictions (NS, NB, Manitoba, Saskatchewan, Québec and BC) – but not to investment funds. Here are the key features of this exemption:

Offering Size. A single offering can’t exceed $250K, up from the $150K maximum originally proposed.
Distribution Period. The distribution can remain open for only 90 days.
Maximum Investment. An investor may invest a maximum of $1,500 in any single investment under the exemption.
Annual Maximum. The issuer can only use the exemption a maximum of twice in a calendar year. With the maximum offering size at $250K, the issuer can raise a total of $500K in a year.
Registration. Crowdfunding portals are not subject to a registration requirement under securities law if they meet certain criteria, including:
- their head office must be in one of the participating jurisdictions and their promoters, directors, officers and control person must be Canadian residents
- they can’t provide investment advice or be related to the issuer of the securities being offered
- they can only allow an investment once the investor confirms online having read and understood the issuer’s offering document and important risk warnings

The main pro of crowdfunding is it gives start-ups a viable alternative to relying only on friends, family and close business associates, or finding and convincing sophisticated people to invest in their business. But there are potential cons. For example, with such a low maximum investment amount, a business would need to find many investors to obtain an appropriate amount of funding, leading to a diverse shareholder base and other sorts of challenges. Also, no crowdfunding activity can take place until a portal is established to permit this type of fundraising, so start-ups and SMEs might not be able to benefit from this exemption just yet. Finally, it’s not proven; only time and experience will tell whether this new start-up crowdfunding exemption in fact develops into a useful, reliable and cost-effective source of capital for start-ups and SMEs.

Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Corporate Finance and Securities Team to discuss this topic or any other legal issue.

McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.

© McInnes Cooper, 2015. All rights reserved. McInnes Cooper owns the copyright in this document. You may reproduce and distribute this document in its entirety as long as you do not alter the form or the content and you give McInnes Cooper credit for it. You must obtain McInnes Cooper’s consent for any other form of reproduction or distribution. Email us at publications@mcinnescooper.com to request our consent.

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